source of capital, financial accounting fundamentals, cash budgeting controls

Sources of Finance

You have several options to choose from when you need funds to start a business. Each of these options has its own benefits and drawbacks. For example, some sources of funds carry more risk than others do. Let's learn about the various sources of finance you can use to start a new business. Savings: If you save money with the idea of becoming an entrepreneur in the future, you can finance your own start-up. You will surely need to estimate the amount of investment in advance. Further, investing your own money to start a business could be a risky decision. For example, if your business fails, you might lose all the money you have saved over the years. However, this source of finance also has benefits. Being a sole proprietor, you get to enjoy all the profits that your business makes. You also will not need to make timely payments to investors or lenders. Family and friends: If you have promising business ideas and sales forecasts, you may be able to convince your family or friends to invest in your business. The biggest benefit of these sources is their faith in you and your long-term goals. Moreover, your family and friends might lend you money at low or zero interest rates. This advantage could bring down your future expenses. Further, if you borrow from family and friends, they might give you more time to pay off your debt. In contrast, if you borrow from a bank, you need to make fixed monthly principal and interest payments. There is only one major disadvantage of taking financial help from your family and friends. If your business suffers losses or needs to shut down, it could put a strain on your personal relationships .Bank loans: Banks provide short-term, medium-term, and long-term loans to established businesses. In order to get a bank loan for your start-up, you may have to use your property (house) as collateral. The bank will treat the property as its security against the loan amount. In case you are unable to repay the loan, the bank can legally claim your property and recover its money. You also have the option of signing a personal guarantee agreement with the bank to acquire a loan. Such an agreement gives the bank the right to recover its money from you directly in case you fail to pay off the debt. In such cases, the bank can recover the loan amount by claiming your property, personal assets, or even investments. If you establish your business and repay the loan, it will get easier to secure loans in the future. The bank will know that you are capable of paying your debts. Timely repayment of debt adds to your credibility in the market. Small Business Administration (SBA) loans: If it gets difficult for you to arrange funds from other sources, you may get help from the US Small Business Administration (SBA). The SBA helps small businesses with promising ideas secure loans. However, the SBA does not provide a direct loan to you. Instead, it makes it easier for small businesses to secure loans from banks. The SBA has various loan programs that could help you finance your business. One of the most popular loan programs that the SBA runs is the 7(a) Loan Guarantee Program. In this program, the SBA acts as a guarantor of the loan. The SBA guarantees the lender (bank) that the loan amount will be repaid over a given period. This arrangement considerably reduces the lender's risk, which can help you secure a loan. You can get an SBA-assisted loan only if you do not have any other options of obtaining finance. Further, your business ideas and forecasts also affect the SBA's role in helping you secure a loan Equity financing: You could also choose equity financing to arrange funds for your business. In equity financing, you offer the investor a stake in your business in return for the investment made. Therefore, equity investors partially own your business by providing you finance. The biggest advantage of equity financing is that you do not need to focus on repaying debt, as in the case of banks. Further, you do not need to provide security to obtain funds from these sources. Another advantage of equity financing is the knowledge and experience of the investors. Equity investors may be able to guide you better with your first business venture. Further, equity investors do not hesitate to make a big investment as long as they find the business idea promising. Equity financing has certain drawbacks too. As an entrepreneur, you lose some business control to equity investors. They have a say in all major business decisions. Further, equity investors expect good returns on their investment. Therefore, you need to share a certain amount of your profits with these investors. Another disadvantage of equity financing is the complex paperwork it involves.

Balance Sheet

A balance sheet summarizes what a business "owns" and what it "owes." It shows the financial health of a business on a given day. As you can see to your right, a balance sheet's left hand side, or "debit side," shows what a business owns, that its, its assets. The right hand side, or "credit side," shows what a business owes, that is, its liabilities. This side also shows owners' equity, or the capital invested in a business. According to accounting standards, both sides of a balance sheet should actually be in balance. This gives rise to the fundamental accounting equation: Assets = Liabilities = Owner's Equity If a business's assets exceed its liabilities, it is in sound financial health. It simply means that the business owns more than it owes at a certain point in time. Therefore, it has more resources than financial obligations. This positive difference shows that a business is capable of paying off its debts.

Need for Accounting in Business

Accounting is of prime importance to all business types. Businesses need accounting in order to record, report, and analyze financial transactions. Further, they need accounting to keep track of their cash inflows and outflows, expenses, and profits. For example, financial statements show a business's profitability and financial condition. Both branches of accounting are important for entrepreneurs. Management accounting helps a business make forecasts and develop a strong business plan. Similarly, financial accounting is necessary to record and evaluate a business's financial data.

Accounting in Business

Accounting is the process of identifying, recording, analyzing, and reporting a business's financial data. Such data includes the business's income, expenses, profits/losses, assets, owners' equity, and liabilities. Accounting ultimately helps a business understand and report its financial status. Creating financial statements is part of the accounting function. These statements help investors and lenders decide whether they want to fund a business. Accounting also helps a business calculate and pay taxes, and carry out its responsibility toward the economy.

Basic Accounting Terms

Accounting period: An accounting period is the duration for which a business prepares its financial statements. This duration varies from company to company. For example, it could be a year, six months, or a quarter (four months). Generally Accepted Accounting Principles (GAAP): GAAP is a set of accounting rules and guidelines that all US businesses need to follow. Public and private businesses, not-for-profit organizations, and other businesses need to adhere to these principles. GAAP thus governs the accounting procedures of a business. Other countries in the world follow another format called International Financial Reporting Standards (IFRS) Ledger accounts: A ledger account is a format to record financial transactions. A business maintains a ledger account for each asset, liability, expense, income, and capital (equity). Debit and credit: Ledger accounts are also called T-accounts, because they are in the shape of the letter T. A ledger account has two sides: debit and credit. All asset and expense accounts have debit balances. On the other hand, all liability, income, and capital (equity) accounts have credit balances. Double entry bookkeeping: Under this system of bookkeeping, every recorded transaction results in a double entry. Thus, every transaction affects one or more accounts. Businesses record transactions in the form of journal entries. Journal entries follow the golden accounting rule of debit what comes in and credit what goes out. Let's assume that a business has bought computers worth $15,000 in cash. You can see the journal entry (double entry) for this transaction in the image to your right. In this example, the business debits computers (asset) as they are "coming into" the business. On the other hand, the business credits cash (asset) since it is "going out" of the business. According to this system, every debit has a corresponding credit. Chart of accounts: A chart of accounts is a list of a business's ledger accounts. A business adds or removes such accounts depending on its changing requirements. Revenues: Accounting keeps track of the inflow of money in a business. Revenues refer to a business's incomes. Businesses primarily earn revenue through sales. They can also earn money in other forms, such as interest on a given investment. Expenses: A business needs to spend money to carry out its operations. Such outflow of money takes the form of expenses. Profit: A business makes a profit when its revenues exceed its expenses. Profits are crucial, as they hint at a company's success in the market. Further, investors and lenders consider a business's profits before making decisions about financing the business. Similarly, shareholders (part owners) of a company can earn returns on their investments only if the business makes profits. Loss: If a business's expenses exceed its revenues, it suffers a loss. A business operating at a loss cannot survive long. Investors might not show interest in a loss-making business.

Choosing an Accounting Method

Accrual-basis is the most common accounting method that retail and manufacturing businesses follow. cash-basis accounting is useful to service businesses that have no inventory to purchase. Examples of such businesses include insurance agencies, accounting firms, and realtors. The cash-basis method helps such businesses get a better estimate of their cash flows. However, a business must use the accrual method if its annual sales revenue exceeds $5 million. Similarly, if a business sells its inventory for more than $1 million annually, it must follow the accrual method. Large businesses and companies (public and private) choose the Accrual-basis method. The accrual method helps these businesses with a long-term view of their profitability. Once a business chooses a method of accounting, it needs to follow it consistently throughout its years of operation.

Corporate Taxation

All for-profit businesses in the United States incur an expense in the form of corporate taxes. Corporate income tax is a percentage of a business's profits payable to the government of the country in which the business operates. The profit that a business considers for tax purposes is the amount left after deducting expenses from total revenues. A business needs to pay corporate tax on the profits of its previous financial year. For example, a business would pay corporate tax for the year 2015 in 2016. Corporate taxes vary among countries. Such differences depend on a country's economy, government policies, political stability, and other such factors. On an average, most countries in the world levy a corporate tax rate of 22.6 percent. However, the United States has a corporate tax rate of 39.1 percent for businesses that earn a taxable income over $100,000. The federal government of the United States earns a major part of its income in the form of corporate taxation.

Equity financing further includes three major sources: angel investors, venture capitalists, and Initial Public Offering (IPO).

Angel investors: Angel investors include wealthy individuals or groups who invest in your business for a share in it. These investors provide finance to new as well as established businesses. They are ready to make big investments in promising businesses. Further, angel investors also provide advice and guidance to businesses in which they invest. Venture capitalists: Venture capitalists (VCs) are business enterprises rather than individuals. Venture capitalists invest in businesses that carry a high risk, but also have the potential to earn high returns. VCs usually fund businesses involved in technology that show rapid growth. However, most VCs choose to invest in businesses that are at a developed stage. Therefore, you might not benefit much from VCs while starting your first business. As compared to angel investors, VCs play a bigger role in the business's management. They take part in every decision-making process of the business. This can be a bit of a disadvantage. Initial Public Offering (IPO): Angel investors and venture capitalists are private investors. The finance that comes from such investors is private equity. However, you may also choose to finance your business through public equity. With the help of an Initial Public Offering (IPO), you may sell the shares of your business to the public. Shares are units of ownership of your business. Individuals or businesses that buy these shares become your business's shareholders. You may be able to raise large sums of money by selling your shares or stock to the public. When your business earns profits, you need to pay your shareholders a part of these profits, known as dividends.

Assets and Liabilities

Balance sheet: A balance sheet is a financial statement that summarizes what your business owns and owes. A balance sheet shows the financial health of your business on a given day. It also expresses how efficiently you use your money and other resources. A balance sheet can also help you gain the confidence of investors and lenders. By examining this statement, lenders and investors can make informed investment decisions

Bookkeeping

Bookkeeping, often confused with accounting, is an important aspect of accounting. It refers to the recording part of the accounting process. The process involves recording and storing a business's transactions in financial books. Bookkeeping is concerned with collecting, organizing, and storing accurate financial data. It is an ongoing process, as a business carries out financial transactions every day. Whether it is a small travel expense or a big investment, every financial transaction forms a part of bookkeeping. The process of bookkeeping involves the use of a journal. "Journal" is a French word that means daybook. In terms of accounting, it is a book in which businesses record their financial transactions in chronological order. A business thus refers to its journal to find details about a particular business transaction on a given date. Owing to this feature, the accounting world refers to a journal as the businessperson's diary.

Financial Statements

Businesses need to prepare two crucial financial statements: the income statement and the balance sheet. Let's start by taking a closer look at the income statement. The income statement is the tabular representation of a business's revenues and expenses. This financial statement has different names based on its users. For example, if the users are internal, such as management authorities and directors, it is called the statement of operations or earnings. If a business prepares this statement for external parties, such as investors, it is termed a profit and loss statement. Businesses prepare such a statement for a month, a quarter, or a year. To your right is an example of one such income statement. It begins by listing a business's revenues, such as sales, interest on investments, and so on. Next, the statement lists the expenses that a business incurs. You'll find that the statement shows the cost of goods sold, operating expenses, depreciation, and taxes. In this example, the revenues exceed expenses. The difference between the two amounts, $240,000, is the business's net profit.

Assets

Current assets: Current assets represent your business's cash reserves. Apart from cash, current assets include all assets that you can convert into cash in less than a year. For example, you may have inventory of finished goods, which you can sell in a few months. The value of these goods is a current asset for your business. Similarly, assume that you have sold goods to some customers on credit. These customers might pay you for these goods in the next six months. The payment from these customers is receivable by you. Therefore, it becomes your current asset, also known as accounts receivable. Any of your short-term investments about to reach their maturity period are also your current assets. Let's say you have paid the rent for the office building in advance. You have thus prepaid the expense and are awaiting the service (using the office building). The same idea applies to insurance premiums that you might pay in advance. Such prepaid expenses or advance payments also become your current assets.

Current Liabilities

Current liabilities are financial obligations that a business needs to pay off within a year. Let's look at some examples of such liabilities. Short-term loans: Short-term loans that a business has borrowed in the past are its current liability. Accounts payable: Future payments that a business needs to make to its vendors (for credit purchases) are termed accounts payable. Outstanding/payable expenses: Any outstanding or payable expenses, such as salaries, rent, interest, and insurance, are a business's current liabilities.

Current Assets

Current or short-term assets include cash or assets that can convert into cash in less than a year. Let's look at some examples of current assets. Accounts receivable: Let's say that a business sells goods to a customer on credit. The customer plans to make the payment a few months later. A business recognizes this amount as a current asset called accounts receivable until it receives the payment. Inventory: Inventory or stock includes the amount of goods that a business plans to sell soon. Since the stock is bound to turn into cash in the future, it is the business's current asset. Prepaid expenses: A business may pay the next three months' office rent in advance. Such advance payments or prepaid expenses are current assets, since the business is yet to receive the benefits or service.

Fixed Assets

Fixed or long-term assets are resources that a business does not plan to sell within a year. Businesses use such assets to carry out daily business operations. Further, fixed assets are of two types: tangible and intangible assets. Tangible fixed assets, such as equipment, machinery, land, buildings, automobiles, and furniture, have a physical presence. On the other hand, copyrights, patents, goodwill, and so on are assets that have a monetary value, but lack a physical presence. Therefore, all forms of intellectual property are intangible assets. Most businesses include long-term investments under the category of fixed assets. However, they may appear as an independent item on the debit side of a business's balance sheet

Long-Term Liabilities

Owners' Equity Owners' equity is a business's value after considering its liabilities. Simply put, it is the owner's share of the assets in a business. It includes these items: Personal investment: This component of the balance sheet includes the money that a business's owner personally invests in the business. Shareholders' money: The money that shareholders invest in the business is owner's equity. Net profit/loss: Any net profit that a business makes in the current year adds to the owners' equity. However, if a business suffers a net loss, it needs to deduct this amount from the total owners' equity. Retained earnings: Owners' equity also includes a business's retained earnings. Retained earnings refer to the portion of a business's profits that it has saved over the years. A business may choose to reinvest this amount for its growth.

Stages of Seeking Capital

Seed capital: Seed capital is the amount of money you need to start a business. At the initial stage of the business, you may invest your own capital, ask for funds from friends or family, or seek help from other sources. At this point, your business exists in the form of a concept or design. Therefore, you must make certain estimates to seek seed capital. For example, you can use market data to forecast demand, costs, and product sales. Potential lenders, such as banks, and investors need such information to decide whether they want to fund your business. So, these estimates need to be accurate and realistic. Other factors play a role in obtaining seed capital from external sources. These factors include as your financial and technical backgrounds, work experience, skills, and business ideas Working capital: Working capital refers to the capital required to cover the operating expenses of your business. Operating expenses are the expenses that relate to your daily business operations. These expenses continue throughout the entire life of a business. Because sales don't always happen at the same rate as expenses, you need a reserve of funds to cover operating expenses. This reserve is useful when waiting for the sales revenue to arrive. For example, if you sell goods on credit, you would receive sales revenue a lot later. Therefore, in addition to seeking seed capital, you may also have to raise or reserve money to finance working capital for a new business. However, when your business picks up speed, you may be able to source such expenses even from the sales revenue. Monthly operating expenses typically include raw materials, utilities, inventory costs, office rent, employee wages and salaries, and insurance premiums.

Role of Tax Accountants

Tax accountants file a business's tax returns according to new laws and requirements. They also document the returns in the standard format. Tax accountants are well aware of any legal consequences that may result from certain business transactions. Therefore, they provide suitable advice to their clients. Tax accountants also help a business prepare a strategy that will help lower a business's income tax. The strategy is based on the business's nature as well as its financial needs.

Alternative Accounting Principles

The Generally Accepted Accounting Principles (GAAP) is a set of accounting standards maintained by the Financial Accounting Standards Board (FASB). GAAP guides US-based businesses with respect to accounting procedures. It is concerned with the method that a business uses to record its financial transactions. Accounting practices that form part of GAAP ensure consistency in a business's financial reports. These accounting principles are limited to businesses operating in the United States. Around 110 countries in the world follow a similar framework, known as the International Financial Reporting Standards (IFRS). The two accounting models have some similarities but several differences. For example, GAAP has different rules for for-profit and not-for-profit businesses. On the other hand, IFRS applies the same accounting standards for all types of businesses

Relationship between the Income Statement and Balance Sheet

The income statement and balance sheet of a company are interrelated. An income statement shows a business's inflow and outflow of money over a period. On the other hand, a balance sheet shows a business's financial standing on a given day. Further, the current year's income statement plays a major role in the preparation of the balance sheet for a given day. Consider the example of a balance sheet that you see on your right. Let's say that the business incurs certain expenses and earns revenue in the next three months. If the business pays salaries worth $5,000 during this time, its liability (salaries payable) would decrease to $5,000 (from $10,000). Similarly, as the business is paying money, its cash would decrease from $10,000 to $5,000. If the business recovers $2000 from its customers, its accounts receivable would reduce to $13,000 from $15,000. However, its cash would also increase by the same amount. If the business makes a profit, it would add to the owners' equity. However, a loss would reduce the owners' equity by the same amount. Therefore, the current year's income statement and the previous year's balance sheet are necessary to prepare the latest balance sheet for a given day.

Indirect method

The indirect method of computing cash flows is complicated. However, businesses use it more often than the direct method. The reason is that the indirect method uses the business's accrual information from the balance sheet to reconcile the amount of net income. This method compares the balance sheets of two consecutive years. The changes in the values of current assets and current liabilities of the two balance sheets reflect in the indirect method. This method calculates cash flows from operating activities using an indirect approach. As you can see to your right, the statement begins with the net income. This method makes noncash adjustments to the net income to determine Total (A). For example, the method adds back depreciation. It is not a cash expense. A business does not pay cash while recording depreciation. So, adding depreciation back to the net income nullifies its effect.

Branches of Accounting

There are two major branches of accounting: financial accounting and management accounting. Financial accounting refers to a business's practice of maintaining financial reports for its stakeholders. Such reports take the form of financial statements, such as the income statement, balance sheet, and statement of cash flows. Lenders and investors need such financial data to decide whether they want to fund a given business. Management accounting caters to the accounting needs of a business's management. It is primarily concerned with the preparation of a business's sales forecasts and budgets (projected incomes and expenses). This branch of accounting helps a business's management analyze information, assess risks, reduce costs, and make financially sound decisions.

Methods of Reporting Cash Flow

There are two methods to prepare a cash flow statement—direct and indirect. Let's study each of these methods. Direct method The direct method of preparing a cash flow statement begins with a business's cash in hand at the start of the accounting period. The details needed to create a cash flow statement are present in a business's current income statement and its balance sheets for the last two years. The direct method has a simple way of calculating the cash flow from operating activities. It includes the cash inflow or revenue from sales of products and services, interest on investments, and dividends. The cash outflow activities include administration and selling expenses, cost of raw materials, and tax and interest payments. Under the direct method, the difference between the total revenue and total expenditure is the net cash generated from the business's operating activities. The direct method then considers the cash flows from each of the three types of activities. After accounting for all cash transactions, the statement arrives at the net increase or decrease in the business's cash.

Calculating Working Capital

Working capital is also referred to as the liquidity of the business. An easy way to calculate working capital is subtracting your business's short-term liabilities from its short-term assets. Liabilities represent the money that your business owes others. On the contrary, assets stand for what your business owns. Short-term liabilities are payments that you expect make in the next 90 days. For example, salaries payable to employees in a month are a short-term liability. Similarly, short-term assets include cash that you have, or the cash that you may expect to receive in the next 90 days or less (accounts receivable). For example, you may be expecting payments from customers in a few days. The difference between your current assets and current liabilities is your working capital. In order to pay for operating expenses, your business's working capital needs to be positive. In other words, the money that you own should exceed the money that you owe for 90 days. Growth capital: All entrepreneurs expect their businesses to grow over the years. A few years after starting your business, it may establish itself in the market firmly. It could have a strong customer base that bolsters sales revenue as well as profits. You might then want to explore new markets or launch new products and thus expand your business. You might invest to buy new technology, hire more employees, and run large-scale advertising campaigns in new cities. Such expansion requires additional investment. Funds that your business needs in order to expand are called growth capital or expansion capital. Generally, businesses need such capital only when their strategies have succeeded in the market. In other words, if your business model has performed well, you may choose to expand your business to earn more profits in the future.

The Cash Flow Statement

t Regardless of the accounting method, every business needs to keep a track of its cash flows. However, tracing the flow of cash during financial transactions for a longer period is a challenge. Therefore, the cash flow statement plays an important role for all businesses. The cash flow statement records the cash that a business pays and receives during an accounting period. It shows the net increase or decrease in a business's cash reserves during this period. The cash flow statement is similar to the income statement. The primary purpose of the income statement is to find the business's net profit or loss. Similarly, the purpose of the cash flow statement is to calculate the amount of cash left with the business by the end of an accounting period. The cash flow statement reports the cash generated and used in three categories: operating, investing, and financing.